1 Regulation Fueling This High-Yield Sector

These days, regulators have become the banks' worst enemy. From multibillion-dollar settlements to the Consumer Financial Protection Bureau and Basel III rules, banking is more regulated than ever.

Luckily, a more aggressive regulatory environment is only helping non-bank lenders gain lending volume, market share, and profits.

High-yield stocks getting a lift
Few investors have heard of business development companies. The industry lends to small companies, generally to finance buyouts by private equity investors, and pay massive dividends of 10% or more per year. The biggest players are Ares Capital (NASDAQ: ARCC  ) and Prospect Capital (NASDAQ: PSEC  ) , two companies with combined balance sheets topping $13 billion.

Historically, BDCs had to compete with banks to find new borrowers. The industry was especially competitive given that the average loan would price with interest rates topping 10% per year. The pricing is because of the risk -- these are loans with little collateral, with the business' future profits expected to back loan payments. Ares Capital and Prospect Capital provide "cash flow loans," based on a businesses' cash flows, not its existing assets like real estate or accounts receivables.

How banks were pushed out
The Office of the Comptroller of Currency issued a note that details how banks can participate in leveraged loans. The new guidelines will put increased scrutiny on banks that lend at multiples greater than six times EBITDA. For example, a business with earnings before interest, taxes, depreciation, and amortization of $100 million could not be financed by a bank if it were to take on more than $600 million in debt.

How do these limitations match up with the industry? Poorly.

At six times EBITDA, an asset-light, service business would be valued at about 10 times earnings after taxes. And asset-light service-oriented businesses make up the bulk of middle-market borrowers -- they're borrowers that can actually afford to repay a loan priced with 10% interest paid in cash.

"Unfair" rules are great for BDCs
If there is one word to describe the guidelines from the OCC and the Federal Reserve, it's unfair. The reason is simple: New limits on leveraged lending are completely arbitrary.

Whereas six times EBITDA might be far too much debt for an oil company that has inherently high capital expenditures, it's a tiny multiple for a cash-generating, capital-light business like a software company. The rules, however, make no distinction between "good" borrower and "bad" borrower. All borrowers levered at more than six times EBITDA are, in effect, "bad" borrowers.

Luckily, the regulatory environment doesn't extend to non-bank lenders like business development companies. Ares Capital and Prospect Capital are free to lend to any company they want, at any multiple they wish. Thus, a deal at 6.5 times EBITDA may be out of reach for traditional banks, but fits squarely in the portfolio of Ares Capital or Prospect Capital. 

The Foolish bottom line
Regulatory changes from the OCC and Federal Reserve will have the greatest impact on the largest BDCs that directly compete with commercial banks for deals -- larger BDCs like Prospect Capital and Ares Capital. Over time, this should lead to better-quality borrowers turning to non-banks, while limited competition will only drive loan pricing higher. It's good for non-banks, bad for the banks. 

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